Which of the following best expresses Free Cash Flow (FCF) used in a discounted cash flow model?

• A. Net Income + D&A - CapEx - ΔWC
• B. EBIT*(1-tax) + Depreciation & Amortization - CapEx - Change in Working Capital
• C. Net Income + D&A - CapEx
• D. Cash Flow from Operations - CapEx - Mandatory Debt Payment

Answer: (B)

Free cash flow in a discounted cash flow model represents the cash generated by operations that is available to all providers of capital after reinvestments. The way to capture this is to start with after-tax operating performance (NOPAT), add back non-cash expenses, and subtract the cash outlays needed to sustain or grow the business.

NOPAT is EBIT times (1 minus the tax rate), reflecting the cash the company would generate from operations if it had no debt tax shields. Depreciation and amortization are added back because they reduce reported earnings but do not consume cash. Then subtract capital expenditures, which are the cash outlays to maintain or expand fixed assets, and subtract the change in working capital, which accounts for additional cash tied up in inventory, receivables, and payables.

Putting it together: FCF = EBIT*(1 - tax) + D&A - CapEx - ΔNWC. This formulation aligns with the idea of cash flow available to all investors after necessary reinvestments, unlike measures based on net income (which includes financing effects) or those that omit working capital changes or treat debt payments as operating cash flows.